If the Fed believes that unemployment is mostly cyclical, it may wait to raise rates. Yet the central bank could be waiting a very long time for displaced workers to re-enter the labor force. Wages (and inflation) could start to rise in pockets of the economy – despite some employment gauges still showing plenty of slack. The central bank could then fall behind the curve – and eventual rate rises would be fast and furious.

In contrast, if the Fed believes weakness in the labor market is structural, as I believe it will ultimately decide, it would likely raise rates earlier than markets expect, but rate hikes would be gradual – and shallower. This is the scenario I expect to occur.

In addition, soft nominal growth means the destination for the fed funds rate will likely be lower than in the past; I believe the ceiling will be near a 3% neutral funds rate versus the historic 4%.

To be sure, it’s hard to predict the exact impact that technology will have on the job market, and there are factors that could arrest the long-term downtrend in rates. However, demand from pension funds and the like, along with limited supply, should also help cap any big rises in long-term interest rates.

Source: BlackRock Research

 

Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Fundamental Fixed Income, is Co-head of Americas Fixed Income, and is a regular contributor to The Blog. You can find more of his posts here.